Newsletter 3

Newsletter, July 5, 2018

10-Year US Yield Rises to Its Highest Level

In 2018 Q2 America’s budget deficit widened due to a rally in oil prices and Trump’s infrastructure proposal. Financed by the increased government debt issuance and public spending, the deficit led to the rise of both the inflation expectations and the consequent rise of the level of the 10-year US yield to the highest level in about three years. Being the driving force of all valuations, the rise of the 10-year US yield, sparked a widespread equity sell-off.

Strong profit growth at S&P 500 companies to be sustained

The main growth drivers are the energy sector with an 87.9% increase and the materials sector with a 39.4% increase, according to Thomson Reuters. According to The Guardian, energy prices are expected to rise since demand has been increasing steadily. According to the same article, material prices are also expected to rise. As a result, this high growth rate can be sustained because the energy companies will have higher profits stemming from the higher energy prices, as well as the material companies will also have higher profits for the same reasons.

New York’s highest court’s decision on a wrongful dissolution case

The New York Court of Appeals recently made a final decision regarding the valuation of a minority partnership interest under a case of a wrongful dissolution from the side of a minority partner. The New York’s highest court determined that several discounts (for goodwill, lack of marketability and minority interest) should be applied to accurately reflect the market value of the minority interest – the value a hypothetical buyer is willing to pay. The ending of this long-lasting litigation was a significant step towards the interpretation of the word “value” in the Partnership Law § 69’s as fair market value.

Surging valuations of private companies based on multiples

According to the “2018 Private Capital Markets Project” from Pepperdine Graziadio Business School, average EV/EBITDA multiples have considerably grown from 2017 to 2018 (from 8x to 8.7x for companies with EBITDA between $25 and $50 million), thus implying an increase in business valuations. The director of this project, Professor Craig R. Everett, mentioned that “Tax cuts and general business optimism are the likely reasons for this new surge in company valuations”.

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The 2018 levels of the Market Risk Premium for several countries

According to a survey (Market Risk Premium and Risk-Free Rate used for 59 countries in 2018, by Pablo Fernandez, VitalyPershin and Isabel F. Acin) which has been conducted by finance professors and researchers, the market risk premium is 5.3% for Germany, 5.9% for France, 6.7% for Spain and 5.5% for the United Kingdom. The indicator is almost at the same levels for USA (5.4%), China (6.3%) and Japan (5.7%), when Greece (15.8%) has the European leading MPR. Furthermore, it is important to mention that the change of the average Market Risk Premium among 2015 and 2018 was higher than 1% for 12 out of 59 countries of the survey.

Companies with high Return on Equity and high Profit Margins

One possible reason explaining why it is difficult for portfolio managers to find companies that combine both high ROE and high profit margins is the use of leverage for making new investments. These new investments increase the Return On Equity, because companies become more profitable using the same amount of equity capital. At the same time, the profit margin shrinks because the company faces higher costs of debt.

Recovery and growth stocks

Those are the two broad categories of investments that the manager looks for. Recovery stocks, although deemed ‘uninvestible’ by the market, have catalysts that could trigger a re-rating, resulting in P/E ratios below 10x and free cash flow yields above 10%. Growth stocks imply strong company growth with predictable earnings prospects and free cash flow typically yielding above 5%.